**1. The Plunge in the Stock Market
The plunge in the stock market has resulted in the wiping out of pension funds and many people's life's savings. It has also been accompanied and reinforced by the allegation of accounting scandals at several major firms, in which key executives were apparently able to reap substantial personal gains despite the destruction of the firms that employed them and the losses of their fellow shareholders.
The combination is operating like the collapse of a dam, unleashing a torrent, not of water, but of hatred--hatred of capitalism and its most visible and valuable representatives: big businessmen. They and their "greed" for profit are depicted as the cause of the collapse.
No less a personage than Alan Greenspan, chairman of the Federal Reserve Board and for many years allegedly a staunch defender of capitalism, has attributed the collapse to "infectious greed." A jeering mob of media-types, armed with microphones and other appurtenances of modern technology instead of knitting needles, is as ready to see businessmen brought down as any mob of the French Revolution was to see the hated aristocrats go to the guillotine.
What is happening must be understood against the background of profound ignorance that exists on the part of today's intellectuals concerning the nature and functioning of capitalism and the profit motive. Despite the worldwide collapse of socialism and the undeniable, visible success of capitalism, the intellectual world, for the most part, remains as predisposed to socialism and opposed to capitalism as ever.
The great majority of today's intellectuals--from newspaper and television commentators to university professors, including most professors of economics, not to mention today's politicians and government officials--regard the failure of socialism and success of capitalism as mere "brute facts," that is, facts without intelligible basis; indeed, facts defying and contradicting all understanding. To know otherwise, they would have had to read and study the works of Ludwig von Mises and the other leading theorists of the Austrian and British classical schools of economics. But this they have not done.
As a result of this fundamental intellectual and moral failure on their part, according to all that they still believe, socialism, with its alleged concern for the well-being of all and its alleged rational planning, should have succeeded, and capitalism, with its concern only for personal profit and its alleged anarchy of production, should have failed.
In the minds of today's intellectuals, the opposite outcome in the real world, must call into doubt the reliability of reason itself--a result, I believe, that goes a long way in explaining the rise in openly professed irrationalism in recent decades, such as the assaults on science and technology emanating from the environmental movement. The intellectuals seize upon today's events in connection with the stock market because they appear to offer a reprieve from the overthrow of their intellectual universe. They believe, for the moment, that they are once again in a position to say that their view of capitalism is confirmed by reality.
The major directly relevant aspects of the intellectuals' ignorance must be countered with a scientific explanation of the actual nature and consequences of the profit motive in a free market, followed by an explanation of how profits are profoundly distorted by forcible government interference in the form of inflation and credit expansion, in ways that directly explain both the stock market boom of recent years and today's stock market bust. In the light of this knowledge, current proposals allegedly aimed at remedying the present situation and preventing its recurrence--but in fact aimed at the further undermining of capitalism--must be exposed and criticized.
2. The Profit Motive as the Foundation of Economic Improvement
What the intellectuals' hostility to profits and the profit motive ignores is that the quest for profit in a free market is the source of virtually all economic improvement.
In a free market, what one is free of or from is physical force, including fraud. Since this principle applies to everyone, one is at the same time oneself prohibited from taking the property of others against their will, which includes taking it by dishonest means. Anything one receives from others must be by their voluntary choice.[1]
In a free market, the way one obtains money from others is by offering them something they judge to be valuable and desire to have. These are the kinds of things one seeks to produce and sell. In this way, the profit motive is the foundation of the continuous introduction of new and improved products and methods of production. The development of new and improved products that people will want to buy, and the more efficient, lower-cost production of what they already want to buy, are the leading ways in which businessmen make profits in a free market.[2]
No less ignored by today's intellectuals is the fact that the overwhelming bulk of profits in a free economy is saved and reinvested, and that the accumulation of any great fortune in a free economy is the result of introducing a whole series of improvements and using the far greater part of the resulting profits to create the means of delivering those improvements to the general public.
Thus, as a classic example, Henry Ford, who started with a capital of about $25,000 in 1903 and finished with a capital of about $1 billion at the time of his death in 1946, was responsible for a major part of the tremendous improvements made in the kinds of automobiles produced over that period and in the efficiency with which they were produced. It was largely thanks to him that the automobiles of 1946 were so far superior to those of 1903 and had declined in real cost from a point comparable to that of a yacht to a point where practically everyone could afford an automobile. At the same time, Ford's growing fortune was invested precisely in the growing production of such improved automobiles. In other words, the other side of the coin of Ford's growing fortune was the general public's growing benefit.
A more recent and equally obvious example of the same principle is the case of Intel. In the early 1980s, Intel was in the forefront of producing what was then the most advanced chip for use in personal computers: the 8086. Competition did not allow the high profits it made from that chip to last very long, however. To continue earning a high rate of profit in the computer-chip industry, it was necessary for Intel to introduce the greatly improved 80286 chip. And then the same story repeated itself, and to continue earning a high rate of profit in the face of the competition always nipping at its heels, Intel had to develop and introduce the 80386, then the 80486, and then successive generations of the so-called Pentium chip.
Intel has made a fortune in the process. Its fortune is invested precisely in the production of today's radically improved computer chips that are produced at a small fraction of the cost of the chips of a decade or two ago. (Of course, the profits earned from any given improvement can often be invested in expanding the production of other, totally different products as well.)
These examples are not isolated. The principle they illustrate operates universally, to the extent that the market is free. Its greatest illustration can be seen in the whole rise in the standard of living that has taken place over the last 100 years. In 1902, the average worker worked about 60 hours a week. What he received in return was the average standard of living of 1902--a standard of living that did not include such goods as automobiles, air conditioners, air travel, antibiotics, refrigerators, freezers, motion pictures, television sets, VCRs, DVD players, radios, phonographs, CD players, or personal computers. Telephones and electric light and power were uncommon. Electric appliances were virtually unheard of. Cell phones, of course, were entirely nonexistent.
The goods that could be produced, such as various kinds of food, clothing, and shelter, were all far more expensive in real terms than they are today--that is, in terms of the time needed to earn the money required to buy them. The diet, wardrobe, and housing of the average person was far more modest then than now. These goods became more affordable and improved in quality and variety only as the quest for profits led to the necessary cost-cutting and other improvements in their production. And all of the goods that did not exist at all in 1902 came into existence only because of the quest for profits.
In other words, what so radically improved the standard of living of everyone was nothing other than the existence of the profit motive and the freedom to act on it as the guiding principle of production and economic activity. Everywhere, in every industry, in every town and city, there were men eager to profit by improving products and methods of production. They were free to do so, and they succeeded. This "greed," "infectious" to the point of being all-pervasive, is what so radically improved the standard of living of the average person. It is something we should all be profoundly grateful for. To whatever extent it would have been less "infectious" and less pervasive, the improvement in the standard of living would have been less.
The extent of the improvement for the average person can be gauged from the fact that his standard of living of today can be taken as at least 10 times that of 1902, and it is obtained by performing on average only two-thirds as much labor--40 hours of labor per week instead of 60. Thus, two-thirds the labor of 1902 now earns the money sufficient to buy 10 times the goods! A mere tenth of that two-thirds, or 6 2/3 percent, is today sufficient to buy goods equivalent to the average standard of living of 1902. This means that on average, thanks to the greed of businessmen and capitalists, there has been a fall in real prices since 1902 on the order of 93 1/3 percent!
3. Inflation, Or Why Prices Keep Rising Despite the Profit Motive
Of course, outside of the field of computers and their peripherals, and a few other goods, such as VCRs and pocket calculators, there is very little obvious evidence of the fall in prices. While real prices have fallen dramatically, prices expressed in paper money have for the most part risen just as dramatically or even far more dramatically. This is because prices today are expressed in terms of irredeemable paper money.
No natural scarcity limits the supply of such paper money, and it is virtually costless to produce. If its production were open to free competition, it would quickly become worth no more than paper clips, pins, or small metal staples, which are goods with a comparably minimal cost of production. The prices of all of the more significant goods expressed in terms of it would be in the many millions at least, just as the number of paper clips et al., at a penny or less each needed, to equal the price of a new automobile, say, is already in the millions. Indeed, irredeemable paper money would become valueless altogether, because the same free market that permitted free competition in its production would offer the alternative of far superior monetary media, notably gold and silver, which would proceed to takes its place as money and utterly eliminate any demand for it.
What prevents the immediate total destruction of the value of irredeemable paper money is that its issuance is a monopoly privilege of the government. This makes possible a slower, more protracted decline in its value, though one which is still substantial and is inexorable. So long as irredeemable paper money retains any of its value, the government that issues it is in the position of having a still valuable item to offer which it can obtain at virtually no cost. A vast array of pressure groups want money from the government, and it can obtain their support by giving it to them. In other words, the government inflates the money supply in order to buy votes. This inflation of the money supply makes the value of the monetary unit decline. Prices rise despite the great success of businessmen in making goods ever more abundant and less expensive in real terms, because paper money becomes more abundant and cheaper at an even faster rate.
4. The Effect of Inflation and Credit Expansion on Profits
The government's inflation of the money supply has a major bearing on profits as well as on prices, and--by means of these two connections--on the stock market, as I will show. In the very nature of the case, an expansion of the money supply operates to raise profits. Profits are the difference between sales revenues and costs. The expenditures that constitute the costs are usually made in advance of the receipt of the sales revenues, sometimes even decades before. Such is the case of expenditures to construct buildings that are depreciated over 40 years or more, which means that the expenditures to construct them show up as costs over a 40-year period, typically, one-fortieth per year. To the extent that the quantity of money and thus the volume of spending in the economic system increases over time, the sales revenues of later periods tend to exceed the relevant outlays made in earlier periods for factors of production, by a correspondingly wider margin, which, of course, means that profits are increased. [3]
The rise in profits is still further increased to the extent that the banking system, operating with the government's sanction, and under its protective umbrella, enters into the process of money creation and engages in credit expansion--i.e., the granting of loans out of newly created money. As Ludwig von Mises has shown, credit expansion creates the appearance of a larger supply of capital and serves to reduce the market rate of interest below what it would otherwise be.[4]
To the extent that this results in the undertaking of longer processes of production, and insofar as this means that processes of production are undertaken in which the outlays for factors of production take a longer time before they show up as items of current cost, there is necessarily a further rise in profits. This is because while such production expenditures make the same contribution to sales revenues in the economic system--i.e., they constitute the sales revenues of the sellers of capital goods and, insofar as they constitute wage payments, they enable the wage earners to make expenditures for consumers' goods--their appearance in business income statements as items of current cost is more or less significantly deferred to future periods, with the result that the magnitude of costs appearing in the income statements of the present period is reduced and profits in the economic system are correspondingly increased.[5]
The recent accounting scandal at WorldCom can perhaps help to illustrate the principle that is present. WorldCom allegedly reported almost $4 billion of additional profits by virtue of wrongly classifying expenditures of that amount for routine maintenance, which should have appeared as an item of current cost in the very same accounting periods in which the expenditures were made, as items comparable to the purchase of durable assets, whose value shows up as current costs only in future accounting periods. Had WorldCom, without ill effect on its operations, been able to reduce its expenditures for routine maintenance by $4 billion, and had it actually used those funds for the purchase of durable assets, its profits really would have been increased by $4 billion. For it then still would have had the same sales revenues it had, but legitimately $4 billion less of current costs.
To bring about comparable effects on profits in the economic system as a whole, it is not necessary for credit expansion to achieve a reduction in the total current costs recorded in any given year in the economic system in comparison with the year before. Credit expansion causes an increase in profits to the extent that it represents a concentration of the new and additional production expenditures taking place over a period of years on factors of production whose acquisition values show up as items of current cost only with more or less considerable delay. This will certainly be the case to the extent that the funds made available by credit expansion are used to finance equipment purchases and the construction of factories and office buildings.
The result of this is that while the increase in the quantity of money and volume of spending that credit expansion entails brings about a certain rise in production expenditures and sales revenues, the tilt of the production expenditures to showing up as costs further in the future serves to retard the rise in current costs and to correspondingly enlarge the increase in profits in the economic system.
It should be realized that any given amount of credit expansion is capable of increasing production expenditures and sales revenues many times over. For example, it is possible that credit expansion in the amount of $100 billion could increase production expenditures and sales revenues by $1 trillion or more and, conceivably, could also increase profits by $1 trillion. This would be the case, however unlikely, if the entire $100 billion of sales revenues initially generated by the credit expansion were entirely saved and then re-expended as a second $100 billion of production expenditures. This second $100 billion of production expenditures would generate a second $100 billion of sales revenues. If the same story were repeated eight more times within the same year, the total of an additional $1 trillion of production expenditures and sales revenues would be reached. A full trillion dollars of additional profit in the economic system would result if the entire amount of additional production expenditures were of a kind that would not show up as current cost until after the end of the current year.[6]
An increase in profits also takes place to the extent that credit expansion causes additional consumption expenditure over and above that of wage earners made possible by additional production expenditure. Credit expansion causes an increase in such consumption expenditure both directly and indirectly. It does so directly insofar as it makes possible the granting of additional home-mortgage loans and additional consumer-installment credit. These enlarge the demand for such things as new homes, home furnishings, major appliances, and automobiles, and correspondingly increase the sales revenues and profits of the sellers of these goods. Credit expansion indirectly increases consumption expenditure to the extent that the higher profits and, especially, the rise in asset values that it generates, notably the rise in stock prices and real estate prices, provide a seeming basis for stepped up consumption spending. (The rise in stock prices will be discussed further, very shortly.)
Additional consumption spending is a source of additional profits perhaps to an even greater extent than is the tilt of production expenditures more to the future and the corresponding deferral of the appearance of current costs. Consumption expenditure, as John Stuart Mill pointed out more than a century and a half ago, is not a demand for labor (except to the extent that it literally constitutes a payment of wages, as in the case of a housewife's employing a maid). Nor is it a demand for material factors of production. It is sales revenues to the sellers of consumers' goods. And that is all.
Most of this additional sales revenue constitutes additional gross profit. Additional cost is present only to the extent that the additional consumer demand is met by selling additional goods out of inventory. To that extent, the additional consumer spending is accompanied by the incurrence of additional cost-of-goods sold. Additional cost may also be incurred to the extent that there is additional commission cost.[7] For the rest, the additional sales proceeds constitute additional profit. Additional demand for labor and material factors of production depends on the extent to which the sellers of the consumers' goods save their sales revenues and profits and use them for the purpose of making additional production expenditures. And in that case, the extent to which there will be additional current cost, or when there will be additional current cost, depends on how long it will take for the production expenditures to show up as current costs.
To the extent that instead of saving, the sellers themselves consume their additional sales revenues and profits, or pass them to stockholders by means of dividend payments or repurchases of outstanding stock, and the stockholders consume the proceeds, there is only further consumption expenditure and a further addition to sales revenues and profits elsewhere in the economic system. The same is true to the extent that the additional sales proceeds are seized by the government as taxes and then consumed by the government.
5. Credit Expansion and the Stock Market Boom
The boom in profits caused by credit expansion is accompanied by a corresponding and even more than corresponding boom in the prices of stocks, insofar as credit expansion provides new and additional money that enters the stock market. Newly created money that is lent to corporations to buy back some of their own shares--a common practice in the last boom period--or to engage in mergers or acquisitions through the purchase of shares in other firms, places funds in the hands of the sellers of those shares. They in turn use the money they receive, or at least the far greater part it, to buy shares in other firms.
The sellers of those shares, in their turn, buy the shares of still other firms. Thus, the new and additional money that enters the stock market travels from one stock or set of stocks to another as a new and additional demand, raising stock prices in the process. And once under way for a while, the rise in stock prices is further fueled by the attraction of funds from all kinds of investors eager to cash in on the prospect of continually rising stock prices. The rising profits of business are thus accompanied by stock prices at rising multiples of those rising profits.
As already indicated, the rise in stock prices is responsible for the share of profits that is consumed being artificially increased. In the absence of credit expansion and its effect on stock prices, increases in profits would be heavily saved and reinvested. A businessman with high profits in such conditions would think of himself as growing rich only to the extent that he used his profits to add to his capital, i.e., saved and reinvested them. But to the extent that the rise in stock prices outpaces the accumulation of capital in this way, businessmen think of themselves as already that much richer and able to afford to consume more without in fact first actually being that much richer. This is a major way in which credit expansion undermines saving and capital accumulation.
Fortunately, the boom in profits and in stock prices caused by credit expansion is not sustainable. If it were, the economic system would suffer in two major ways: the demand for consumers' goods would be permanently increased relative to the demands for capital goods and labor. And the demands for capital goods and labor themselves would be permanently distorted in favor of capital goods and labor serving the more remote future at the expense of capital goods and labor serving the less remote future. The result of these developments would be a substantial undermining of capital accumulation, possibly to the point of bringing about economic retrogression. The rise in the productivity of labor and in real wages would thus also be undermined if not reversed.[8]
6. Why the Credit-Expansion Boom Cannot Be Sustained
One reason why the credit-expansion boom is not sustainable is that many of the projects financed by credit expansion are doomed to suffer major or total financial loss.